Hedge… Not a Four-Letter Word: Hedging Tricks With Options

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By
Scotty Defoe

October 1, 2011

Fredrik Broden

Lunch? Lunch is for wimps. Hedging, though? Not so much, especially with options. Risk is risk. So whether you’re an investor or a trader, everyone needs to protect against the downside—no matter what time frame is involved. Traders (particularly stock traders) may not want to be compared to “investors,’ but at any given time, whether you hold one stock or ten stocks, it’s still a “portfolio,” even if only for a short while. So you still need to protect your basket—particularly if you’re timing market swings.

Traders (particularly stock traders) may not want to be compared to “investors,’ but at any given time, whether you hold one stock or ten stocks, it’s still a “portfolio,” even if only for a short while. So you still need to protect your basket—particularly if you’re timing market swings.

For investors, hedging a typical buy-and-hold strategy might look complete with a healthy mix of stocks across different industries. The logic is that if industry #1 goes down, the other, entirely different industry #2 is immune to whatever plagued industry #1. If, for example, gaming companies suddenly fall out of favor because a recession hits, broke consumers aren’t likely to stop buying toothpaste and soap. In fact, money might come out of gaming and go into “safer” stocks such as consumer staples. But what happens if another black swan hits again and everything comes crumbling down at once, despite your best efforts to “hedge” in the traditional sense?

Fortunately, the hedging tricks with options are designed to protect both camps. And when it comes to an options hedge, the simplest choice is usually the preferred one. This is not to say that just because you have a hedge, you’re not going to have any losses. In the hedging strategies that follow, you’re buying options, which means you’re paying for premium to protect against your downside. It’s merely a matter of picking the right class of option with the right strike and the right duration.

But the question is, how?

How Much Time Do You Need?

When buying options as a hedge, you'll need to decide how much time you think you’ll need for your long hedge. The shorter the time, the cheaper the options. But go too short in duration and your hedge decays too quickly. On the other hand, go too far and it just costs too much in dollar terms. If you’re swing-trading stocks (holding longer than a day, but less than two months), you could look at options that expire anywhere from one week (if weekly options are available) to two months out. This will give you enough time to provide an effective hedge, but not so much time that it costs an arm and a leg. And you can always buy another hedge if you find you need more time.

Picking the Right Hedge

While the following strategies all involve buying options, by no means is this a complete list— just a simple one. Nevertheless, you can experiment with option spreads that might work better under certain conditions, such as when volatility is extremely high and long options prices are inflated.

1. Eyeballing The Option Strikes

If you want to hedge each stock individually, deciding on which puts to buy can be a bit of a trick since options don’t appreciate in a straight line. If you’re starting with at-the-money puts, for example, and your delta is 50, all things being equal, you’ll earn $50 on your put if the stock moves one dollar. But if you start with an out-of-the-money put with a delta of 25, you’ll only earn $25 on the same dollar move in the underlying.

Option greeks aside, there’s a way to calculate how much an option hedge will protect you without making things complicated: eyeball the option prices of two adjacent strikes in an option chain. In other words, look at the difference in price between the one you want to buy and another that’s one strike deeper in-the-money. Here’s how it works:

Subtract the hedge premium from the next strike premium ($5.30 - $3.60 = $1.70, or $170 per contract). Should the stock suddenly fall the distance between strikes ($5 in the example), you’ll offset your position by approximately that amount ($170).

At this point, you simply calculate how much of a hedge you think you need. The trade-off is as follows:

Scenario 1: You buy the 50 put and pay $5.30 to hedge every dollar that the stock drops below its current price of $50. This is the more expensive of the two choices, resulting in a higher break-even if the stock goes up, but you obtain full protection with every cent that the stock drops.

Scenario 2: You buy the 45 put, pay $3.60, and hedge every dollar from $45 on down. This choice is less expensive up front, but costs more if the stock drops lower than $44.70.

2. Index Options

Rather than buy protective puts on every holding, sometimes it makes more sense to simply buy them on an index that closely follows the performance of your portfolio. First, you’ll need to decide which index is the most appropriate, of course, but for the moment, let’s assume your portfolio reflects a “diversified” mix of stock positions that can be found in the S&P 500 Index—in which case, you might use SPX puts to hedge your long portfolio.

Next you need to figure out how many options to use, and there are a few moving parts to work through before determining that.

STEP 1: Determine the cash value of the index

Let’s say SPX is 1300. The value of a play that gets you short 100 “shares” of SPX gets you short $130,000 worth of the market. You can get that by multiplying the price of the index (1,300) by 100.

STEP 2: Calculate the number of puts you’ll need

Say you’re looking to hedge $250,000 worth of long positions. That’s a little less than twice the value of 100 “shares” of SPX, but let’s call it 2X. Essentially, you need to get short 200 shares of SPX. A put option on the SPX represents 100 “shares” of the index. Hence, in order to control 200 short shares of SPX via put options, you would need to buy two puts—provided, of course, you weight your portfolio equally to how you would weight an index. (It also depends on the “beta” of what’s in your portfolio, which we’ll get to next.) And don’t forget to factor in transaction costs or fees that could affect your net hedge.

A tip on how much time to buy for index options: Unlike single stock options, the volatility term structure in index options tends to be pretty smooth. Single-stock options see blips of volatility strength along the way as news events pop up. If we happen to be in a market environment where index option volatility levels are higher for longer-term options than for shorter-term ones, then we have to give serious consideration to just how far out in time we want to go in order to obtain our hedge. That’s of course on top of the higher dollar price to begin with thanks to the value of having longer to wait until expiration. So you really don’t want to go too far out. Again, like a single stock, something in the first two expiration cycles that sits in the three- to six- week range usually works best.

3. Beta-Weighting

Instead of calculating math, what if you could just push a button that tells you exactly how many index puts to buy as a hedge? Or perhaps your portfolio is weighted too heavily in one sector—say, energy—and you’re looking to hedge with puts on the sector ETF.

In the thinkorswim platform, you can “beta weight” your portfolio against any stock or index. The beta-weighting tool converts the deltas of the individual positions into stock-equivalent deltas for you. It also converts the sum portfolio deltas into the stock-equivalent portfolio.

Suppose, for example, you wanted to beta-weight your portfolio to NDX:

STEP 1: Go to your Position Statement on the Monitor page.

STEP 2: In the upper right portion of the position statement, check the box next to “beta weighting,” type in the symbol “NDX,” then hit Enter.

STEP 3: The index-equivalent deltas for each holding and total portfolio will display. The portfolio delta is the number you would use to determine how many puts to buy to “neutralize” the positive delta number to zero.

Last Thoughts

So far we’ve only discussed puts, but all the same logic applies to calls—just in reverse. In other words, if you have a short portfolio and wanted to create a hedge, you’d consider buying calls. You could take it a step further and hedge with long vertical spreads, too. Hopefully, you picked up some tips for a different kind of hedge here. You might be a trader, or you might be an investor. Either way, you share at least one interest—preserving your capital. As always, these are just guidelines, and personal preferences can vary. Just remember, it’s about finding the best fit for your own situation.

Be aware that assignment on short option strategies discussed in this article could lead to unwanted long or short positions on the underlying security.

Spreads, Straddles, and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. These are advanced option strategies and often involve greater risk, and more complex risk, than basic options trades.

Market volatility, volume, and system availability may delay account access and trade executions.

Past performance of a security or strategy does not guarantee future results or success.

Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.

Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.

The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.

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